Taxpayer Did Not Have Fraudulent Intent

The Tax Court held that a taxpayer
who used an “agent-principal” scheme to avoid paying taxes on
income from his business was not liable for a civil fraud
penalty because the IRS had failed to prove that the taxpayer
had fraudulent intent.

Background

David Carreon and his wife were equal owners of a credit
card processing business, originally as Bancard Solutions LLC
and later as Merchants Payment Processing Inc. (collectively,
Merchants Inc.). In 1999, pursuant to the advice of a
financial adviser, the Carreons began using an asset
management protection and financial strategy referred to as
the “agent-principal” relationship. Under this scheme, the
Carreons took net gross receipts from their credit card
processing business after business expenses including their
salaries and put those funds into various trusts. One of the
trusts, designated the management trust, was managed for a fee
by a company named Builders.

The Carreons employed a
CPA, referred to them by the financial adviser, to prepare
their business and personal income tax returns. The financial
adviser told the CPA about the “agent-principal” relationship.
The CPA accepted the adviser’s assurances that the scheme was
valid and prepared the returns for the Carreons in accordance
with the scheme.

During the years in question, the
Carreons transferred Merchants Inc.’s net income after
expenses to Builders’ bank accounts. Mr. Carreon kept a
QuickBooks file with detailed records of the transfers.
However, Merchants Inc. did not report the amounts that it
transferred to the Builders’ bank accounts as income.

The Carreons also opened several bank accounts not directly
related to Merchants Inc. Either Mr. Carreon or the couple
jointly had signature authority. The Carreons had money
transferred from the Builders’ accounts to these accounts.
Although Mr. Carreon kept careful records of the transfers
from Merchants Inc. to the Builders’ accounts in his
QuickBooks files, he did not keep any records of the transfers
from the Builders’ accounts to these other accounts, and the
checks themselves (which were signed by the financial adviser)
were labeled in a way that made them appear to be charitable
contributions of some type. The Carreons also deposited income
from rental properties in these accounts, and they used funds
transferred to these accounts to pay personal expenses.
However, they did not report any of the funds transferred to
these accounts as income on their federal income tax
returns.

The IRS audited Merchants Inc. and the Carreons
and issued notices of deficiency based on the underreporting
of income due to the use of the agent-principal relationship.
It also assessed Sec. 6663 civil fraud penalties. Merchants
Inc. and the Carreons challenged the IRS’s determinations in
Tax Court.

Eventually, the Tax Court consolidated the
cases for Merchants Inc. and David Carreon; a separate case
for his wife (who was at that point divorced from Carreon) was
not included. After Carreon and Merchants Inc. conceded the
underpayments due to unreported income, the only issue left
for the Tax Court to decide was whether Carreon and Merchants
Inc. were liable for the civil fraud penalty.

The Tax Court’s Decision

The Tax Court
held that Carreon and Merchants Inc. were not liable for the
fraud penalty. The court found that their underpayments of tax
were not due to fraud because they did not have the requisite
intent for fraud.

To prove fraud with intent to evade
tax, the Tax Court explained, the IRS must show by clear and
convincing evidence that a taxpayer underpaid tax for the year
in question and that some part of the underpayment was due to
fraud. Both Carreon and Merchants Inc. had conceded
underpayments of their tax liabilities. Therefore, the IRS
only needed to prove that part of the underpayment was due to
fraud. To do this, the IRS was required to prove that Carreon
and Merchants Inc. acted with fraudulent intent.

The
Tax Court noted that because direct evidence of intent for
fraud rarely exists, it may be established by circumstantial
evidence. To determine whether there was enough circumstantial
evidence to support a finding of fraudulent intent, the court
reviewed the evidence for “badges of fraud.” In the Ninth
Circuit, to which Carreon’s and Merchants Inc.’s cases would
be appealable, the Tax Court found that the badges of fraud
are (1) understatement of income; (2) inadequate maintenance
of records; (3) failure to file tax returns; (4) offering
implausible or inconsistent explanations of behavior; (5)
concealment of income or assets; and (6) failure to cooperate
with tax authorities. To this list the court added the
following badges that other courts have included in their
analysis: (1) engagement in illegal activities; (2) cash
transfers; (3) filing false documents; and (4) offering false
or incredible testimony.

The court analyzed the
evidence for fraud separately for Carreon and Merchants Inc.
In Carreon’s case, it found that three of the factors favored
a finding of fraud, six were against, and one was neutral and
concluded that the IRS had not proved that Carreon had the
requisite intent for fraud. In Carreon’s favor, the court
found that his understatement of income was due to his
reliance on his advisers and that while this reliance was not
necessarily reasonable, it was not fraudulent; he had filed
his tax returns; his explanations of his behavior were
generally consistent and plausible; he did not engage in any
outside illegal activities; he did not use cash transfers; and
he did not give false or incredible testimony. In its
discussion of his explanations of his behavior, the court
admitted that some of his behavior was suspicious, but
asserted that suspicious circumstances alone do not sustain a
finding of fraud.

In Merchants Inc.’s case, the Tax
Court also found that the IRS had not proved fraudulent
intent, but the opinion only discussed five of the 10 fraud
factors, four of which it determined were against finding
fraud. It once again concluded that the company’s
understatement of income was merely due to unreasonable
reliance on its advisers, that the company had filed its tax
returns, and that it was not engaged in any illegal
activities. The court also found that the company had not
filed any false statements with the IRS because the IRS had
not alleged the company had. According to the court’s
discussion of its analysis for Carreon, the IRS had not
alleged that Carreon had filed any false statements either,
but in Carreon’s case this badge weighed in favor of a finding
of fraud because Carreon filed incorrect and thereby false
returns when he did not report or disclose that Builders paid
his personal expenses. The only thing the court found that
weighed in favor of a finding of fraud was that the company
maintained inadequate records because the company did not keep
details of why its payments to Builders were deductible and
why some of the funds it paid to Builders were used to pay the
Carreons’ personal expenses.

Reflections

Based on the applicable law and
Tax Court precedent, the court arguably came to the correct
conclusion in this case. Even though the magnitude of the
taxpayer’s underpayments suggest that he must have known that
he was not properly reporting his income, his actions did not
prove that he knew: Ignorance and bad advice may have been to
blame for his tax underpayments.

Regardless of whether
the Tax Court reached the correct result in this case, it has
once again approached the weighing of the badges of fraud in a
way that does not make sense. In cases such as this one, the
court weighs the various badges of fraud equally, so that the
absence of a particular badge of fraud counterbalances an
established indication of fraud. A taxpayer with only a few
indications of fraud will never be found to have acted with
fraudulent intent under this approach no matter how strong
those indications are.

Rather than counting up the
badges of fraud and seeing if they outnumber the nonfactors,
the court should use the list of the badges of fraud only as a
guide for the evidence the court should consider. After
determining which factors point to fraud and how strongly they
do, the court should evaluate the taxpayer’s entire conduct as
a whole in making its decision. Under this approach, strong
evidence of a few badges of fraud would be enough to convince
a court that the taxpayer acted with fraudulent intent.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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